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Service tax on foreclosure charges is usury
June, 30th 2008

PRECLOSURE OR foreclosure charges collected by banks and other companies as part of their lending and financial services will attract service tax, according to a clarification issued by the finance ministry of the government of India. Foreclosure or preclosure charges refer to the penalty that a lender collects from a borrower when the borrower closes the loan account prematurely or before it is to be closed in terms of the loan agreement. Common sense and received wisdom tells us that such borrowers should be rewarded by allowing them a rebate. But these days, in India, as is the case elsewhere, following international practices in these matters (mind you international practices are American practices; whatever is American is international and the vice-versa is not necessarily true) are not just a fad they are here to stay. Whether they are healthy or unhealthy for our economy is secondary. So, not only Indias hi-tech private sector banks but even the finance ministry of the government of India has deemed it fit to go international. After all, the ministry is headed by a Harvard-educated scholar. How can it afford to be otherwise?

Thanks to the trend, our banks and financial institutions have designed their own version of the sub-prime loans in the form of retail loans. Typically, the loan agreement lays down that if the borrower forecloses the loan account (ie closes the loan account before the due date), he/she has to pay a penalty. The penalty is computed as a percentage of the loan outstanding and generally this percentage is two. The concept underlying the penal clause is that if the borrower returns the money before the due date, then the lender will have to find another borrower to lend the returned money. Additionally, it may not be possible for the lender to re-lend the returned money at the same rate of interest. The lender may have to incur a loss for a mistake he has not made. Hence, to compensate the lender against such potential loss, the penal clause is incorporated.

Typically, only a small number of borrowers opt for foreclosure in our country, the reason being that the demand for funds always outstrips the supply of funds. The lender therefore does not have to sweat it out to find another borrower to re-lend the money returned by the borrower before the agreed date. Even assuming that when the returned money is re-lent, the interest rate has taken a hit and hence the lender can re-lend only at a lower rate, it is worth remembering that such instances are few and far between in our country. In the circumstances, the finance ministry laying down that service tax is payable in respect of the foreclosure charges (penalty) is something, which even the loan sharks will not approve of.

Being an indirect tax, service tax comes under the purview of the Central Board of Excise and Customs (CBEC), which has taken a stance that preclosure/foreclosure charges are not in the nature of interest. Foreclosure charges are not charges collected for delayed payment. As foreclosure charges are not interest, they are being treated as consideration for service provided and hence liable to service tax. This strictly technical interpretation may help the CBEC in justifying its stance but such justification is based on perverted logic. It is high time that the government amended the statute to exempt foreclosure charges from service tax. If it does not, I suggest that banks collect the foreclosure charges in the form of interest from the borrowers. To this effect, banks can incorporate a clause in the loan agreement. The loan agreement should state that if the loan is foreclosed the borrower has to pay additional interest to the bank to protect the latter from the risk of a possible fall in interest rate. Once this clause is incorporated, service tax cannot be applied, because it will have qualified as income. The borrower and the lender can heave a sigh of relief. Our finance ministry will realise that even those who are not Harvard-educated have brains.

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